THE DATA BEHIND THE CRM II REGULATIONS

THE DATA BEHIND THE CRM II REGULATIONS

Introduction The ongoing CRM II regulations introduced by the Canadian Securities Administrators (CSA) represent a fundamental shift in the industry, aiming to ensure that investors gain a clear and complete understanding of how their investments perform. CRM II is also meant to highlight the fees investors pay and the compensation collected by their investment firm related to their investments. While the regulatory requirements are being phased in over several years, with two milestones already achieved in July 2013 and July 2014, the changes with the greatest impact for investment firms and their clients are still to come, taking effect in December 2015 and July 2016. For these two upcoming regulatory deadlines, it is essential to have the appropriate data available well in advance. This data is necessary to provide the required information to investors via client reporting. Perhaps more importantly, though, having this data prepared ahead of time will allow your firm to make better decisions and prepare your advisors to have the necessary discussions with key investors before the deadlines. This will ensure that investors are not caught off guard by changes in how performance and fees are reported. HAVING YOUR DATA PREPARED AHEAD OF TIME WILL ALLOW YOUR FIRM TO MAKE BETTER DECISIONS AND PREPARE YOUR ADVISORS TO HAVE THE NECESSARY DISCUSSIONS WITH KEY INVESTORS BEFORE THE DEADLINES. In this white paper, we dig deeper into the data required to meet the 2015 and 2016 CRM II regulations, providing a complete overview of elements that you will need from your data provider for each deadline. We also discuss the challenges associated with this data and outline options to satisfy the regulations when certain data elements are not available. 2 3

Data Required Description Due Date Position cost Firms must provide position cost information to investors. Firms have the option to use either book cost or original cost to satisfy the position cost requirement. (Most firms and data providers will be using book cost.) The definitions provided below are from the Investment Industry Regulatory Organization of Canada (IIROC). The CSA is expected to update its book cost and original cost definitions to match the IIROC definitions. Data required to meet the CRM II regulations The following tables summarize the data your firm needs in order to present the information required by the CRM II regulations to your investors for the regulatory deadlines of, and July 15, 2016. Book Cost Definition: 1. In the case of a long security position, the total amount paid for the security, including any transaction charges related to the purchase, adjusted for reinvested distributions, returns of capital and corporate reorganizations; and 2. In the case of a short security position, the total amount received for the security, net of any transaction charges related to the sale, adjusted for any distributions other than dividends, returns of capital and corporate reorganizations. Original Cost Definition: 1. In the case of a long security position, the total amount paid for the security, including any transaction charges related to the purchase; and 2. In the case of a short security position, the total amount received for the security, net of any transaction charges related to the sale. 4 5

Data Required Description Due Date Market value Securities subject to a deferred sales charge if sold Additional information for client name securities The market value of each security must be provided, based on last bid price for long positions and last ask price for short positions. For liquid securities, it is also possible to use the last trade price if it can be demonstrated that there is no material difference between last trade price and last bid/ask price. Situations where the market value of a security cannot be determined according to the above rules fall under two categories: Estimated Market Value: The security is not available on an active market, but your firm is able to estimate the market value for the security based on available observable inputs or, failing that, unobservable inputs and assumptions. Non-determinable Market Value: Your firm is unable to provide an estimated market value for the security. (The market values of nondeterminable securities must be excluded from performance calculations.) Any security that is subject to a deferred sales charge (DSC) when sold must be clearly indicated in the account statements that your investors will receive. Additional reporting on client name accounts and securities is required, identifying the party that holds or controls such securities and how these securities are held. Data Required Description Due Date Investor protection fund Money-weighted performance When an account or securities within an account are covered under an applicable investor protection fund, this information must explicitly be disclosed on the account statement. For example, if your firm is a member of the Canadian Investor Protection Fund (CIPF), then all nominee accounts and securities are covered under CIPF. For client name accounts and securities held outside your firm, it will be necessary for your firm to receive appropriate data indicating whether the entities holding client name accounts and securities are members of an investor protection fund. To satisfy the CRM II regulations for providing money-weighted performance in the investment performance report, the following data elements are required for an annual period (with the first annual report s period starting on or after January 1, 2016, and including July 15, 2016): Opening and closing market values. Market values of deposits, withdrawals, and transfer of cash and securities. Annualized money-weighted performance returns for the previous 1, 3, 5, 10 years and since inception. (Any 3-, 5-, or 10-year periods that include date ranges before January 1, 2016, are not required to be provided.) If the money-weighted performance returns are not provided, but must be calculated, then the relevant opening and closing market values, as well as the dates and amounts of cash flows, are required to calculate money-weighted performance. July 15, 2016 6 7

Data Required Description Due Date Charges and compensation details Trade confirmation charge details To satisfy the CRM II regulations for providing an annual summary of all charges incurred by the investor and all other compensation received by your firm associated with the investor s account, data for the relevant charges and compensation (including compensation received indirectly from the investor via third parties, including trailing commissions and certain referral fees) must be available to be presented to the investor. The amount of individual transaction charges, deferred sales charges or other charges must be displayed on trade confirmations, as well as the total amount of such charges. July 15, 2016 July 15, 2016 FIRMS THAT ARE CURRENTLY PROVIDING ADJUSTED COST BASE TO THEIR INVESTORS... MAY NEED TO DO EXTRA WORK TO PROVIDE BOOK COST ACCORDING TO CSA/IIROC S DEFINITION. Where will the data come from and what are the challenges? For starters, all data providers will be providing book cost. In general, data providers will be calculating money-weighted performance numbers for their firms, and if they are currently calculating time-weighted performance numbers, they may or may not continue to provide this data to their firms. In order to satisfy the book cost definition for CRM II it is no longer possible to use adjusted cost base (ACB) as book cost. Therefore firms that are currently providing ACB to their investors, to assist them for tax reporting purposes, may need to do extra work to provide book cost according to the CSA/IIROC s definition from the deadline of December 31, 2015, onwards. They may also need to put additional effort into explaining to their investors how the reporting of costs of securities has changed, if they choose to replace ACB with book cost. There are three situations to consider: Firm not currently receiving ACB from data provider. Data provider will provide book cost going forward. Firm currently receiving ACB from data provider. Data provider will no longer provide ACB and will only provide book cost going forward. Firm currently receiving ACB from data provider. Data provider will continue to provide ACB and also provide book cost going forward. Conflicting regulatory requirements. The T5008 (CRA)/RL-18 (Revenu Québec) tax forms need to include book cost, but the CRA/Revenu Québec s usage of book cost is not consistent with the usage of book cost under CRM II. For CRM II, the book cost reported allows for a market value to be used in place of book cost when the book cost is unavailable. On the other hand, the tax authorities specifically prohibit the use of market value in the field for book cost on forms T5008 and RL-18. 8 9

The scenario of the book cost being unavailable generally relates to transfers-in, resulting in the use of market value in lieu of book cost in such situations. Depending on the relationship between the delivering dealer and the receiving dealer, for consistency s sake, it may be possible for the delivering dealer to provide the book cost data associated with the transfer-in/transfer-out to the receiving dealer. In this case, the receiving dealer can proceed on the assumption that the book cost provided by the delivering dealer is correct. It is only the scenario where the delivering dealer is unable to provide book cost data to the receiving dealer that results in an unavailable book cost. Currently certain firms have flexibility when reporting time-weighted performance in certain scenarios. For example, if a firm s policy is that accounts opened with less than a certain market value threshold won t have performance reporting start until the account s market value exceeds that threshold, certain providers allow firms to make appropriate adjustments such as allowing the inception date of the account to be adjusted for performance reporting purposes. It s unclear whether or not this is permissible for money-weighted performance for the CRM II 2016 requirements. On the safe assumption that it s not permitted, firms that have similar policies today may need to do extra work to make the appropriate adjustments going forward. With respect to money-weighted performance, there is no general industry consensus on using trade date versus settlement date, and whether or not to include accrued interest. We recommend the use of trade date to determine the relevant market values. We also recommend including accrued interest, based on our experience with calculating money-weighted performance. Under the market value definition required for CRM II, thinly traded securities will not have market values according to the standard use of bid or ask prices, and are not easily estimated in most cases these must be flagged as having non-determinable market values. Since such securities are excluded from money-weighted performance calculations, this can lead to greatly distorted moneyweighted performance numbers. For example, if the majority of an investor s account consists of thinly traded securities with non-determinable market values, the moneyweighted performance for that account will be based on a much lower market value than is actually the case. If the thinly traded securities are high-performing, then their contribution to the actual money-weighted performance is not taken into account, leading to reported moneyweighted performance numbers that are not meaningful and are much lower than expected. In such cases, it may be necessary for firms to perform additional work to explore alternative ways of providing estimated market values according to the regulations. Since IIROC regulations were only finalized on January 19, 2015, data providers are still working through details of how to provide market values, indicators for estimated or non-determinable market values, and other information that investment firms will need. While the recent extension of the original July 15, 2015, deadline to December 31, 2015, is appreciated, there is still not a lot of time for finalized data feeds to be provided to investment firms, followed by investment firms implementing and testing the changes (whether in-house or via external vendors). Looking forward to July 15, 2016, capturing the data required for charges and compensation reports will be challenging. Data providers may currently have large numbers of different entry types relating to fees in their books of record. These will need to be streamlined and reduced to be useful for reporting purposes. The greater concern is how to deal with fees not currently captured in the custodian s book of record, which may include trailing commissions, mark-ups or mark-downs applied to debt securities by your firm, and other payments made to your firm by a securities issuer or another registrant relating to services provided to the investor. As these fees must be provided on the charges and compensation report for July 15, 2016, additional work may be needed to integrate this additional information into the appropriate data feeds to populate the new report. For firms that plan to calculate money-weighted performance, not having appropriate transaction data can be a major challenge. Without transactions, it is difficult to accurately calculate money-weighted performance, and more complicated logic involving approximations will 10 likely be required. 11

How can you manage your existing data? Clean up stale prices before applying new disclosures/disclaimers for market values, to reduce the number of estimated/non-determinable market value occurrences. This will also help your firm identify thinly traded securities, and how prevalent these are in your book. When you identify these your firm can assess the feasibility of providing estimated market values in these cases to provide meaningful money-weighted performance. Identify securities that are missing book cost. The book cost is typically unavailable for securities that have been transferred-in, where the delivering dealer did not provide book cost. In such cases, your firm should define a consistent policy for using market value in lieu of book cost. For example, you could choose market value as of a specific date for securities that are missing book cost as of, and on a go-forward basis, you could choose market value as of the transfer-in date. Analyze your data to identify at risk investors who will see significant changes in their reports and statements before and after the CRM II regulations come into effect. In particular: Investors who currently receive time-weighted performance information may be in for a shock if money-weighted performance is significantly different from the expectations set by time-weighted performance. In the worst case, it is possible for a positive time-weighted performance number to translate into a negative money-weighted performance number. Identifying investors who will see such performance swings far enough in advance will help you plan out valuable discussions that your advisors should have with these investors to properly prepare them for these changes. Similarly, investors who will see a significant increase in reported fees in the charges and compensation report should also be identified for your firm to proactively engage in advance of the regulatory changes. To properly support the calculation of money-weighted performance, we recommend standardizing on a consistent cash-flow assumption. For example, positive cash flows associated with an asset or group of assets may be assumed to be at the beginning of the day, while negative cash flows may be assumed to be at the end of the day. MASS OVERWRITING FOR POSITIONS THAT DON T HAVE A VALID BOOK COST IS MUCH EASIER TO DO ON A SINGLE DATE, INSTEAD OF INDIVIDUAL TRANSFER-IN DATES. What you can do when data isn t available General consensus for book cost: With respect to using market value in lieu of unavailable book cost: There is no requirement to grandfather/go back in time for each position that existed before December 31, 2015. Overwriting 100% of the book costs for a specific security with market value as of, for example,, would violate the spirit of the regulations. Firms we have talked to agree that they should only limit overwriting to instances where book cost is out of line. For example, if 50 investors hold a specific security, such that 35 of them have valid book costs, and 15 don t market value should only be substituted for book cost for the 15 investors without valid book costs, and should not overwrite the 35 investors with valid book costs. Mass overwriting for positions that don t have a valid book cost is much easier to do on a single date, instead of individual transfer-in dates. However, December 31, 2015, is likely not the best date to use, given everything that firms must deal with during year-end processing. It may be easier to choose an earlier date to allow for proper implementation/testing. In the scenario where multiple transactions are recorded for a security over time, and the first transaction results in using market value in lieu of book cost, but a second transaction has a valid book cost, you could flag the security with a mixed flag to indicate that the book cost displayed is a combination of both market value in lieu and actual book cost. This mixed flag could potentially also be provided by the data provider. 12 13

General consensus for performance: We recommend providing the investment performance report at the same time as the corresponding account statement. This offers an integrated client experience and saves on postage for print statements. But logistically this may be difficult, depending on how performance is calculated and/or provided without impacting when account statements are sent to clients. For instance, firms that calculate their own performance can t start performance calculations until they have locked down month-end prices, which may take a couple of days. If performance calculations are fairly intensive, additional time after monthend may be needed to finalize performance numbers ready for reporting. In addition, for firms that will receive money-weighted performance from their data provider, there may be a timing gap between the regular data feed provided to produce account statements and the new data feed that provides the money-weighted performance data. If this gap is significant, it may be quite difficult to integrate the investment performance report into the statement while still delivering the statements on time. References PureFacts CRM II Event. February 12, 2015 IIROC Client Relationship Model ( CRM ) Frequently Asked Questions February 9, 2015 (retrieved from http://iiroc.ca/documents/2015/3d960352- dc4d-4ffd-80e9-01ab4b653d33_en.pdf on February 25, 2015) IIROC Rules Notice Client Relationship Model Phase 2 Performance Reporting and Fee/Charge Disclosure amendments to Dealer Member Rule 200 and to Dealer Member Form 1 January 19, 2015 (retrieved from http://www.iiroc.ca/documents/2015/17577c74-a6fe-4a5e-83c2-617429db1dea_ en.pdf on February 25, 2015) The Ontario Securities Commission Final Amendments to NI 31-103, NI 33-109, NI 52-107, OSC Rule 33-506 and OSC Rule 35-502 and Related Forms October 16, 2014 (retrieved from http://www.osc.gov.on.ca/documents/en/securities-category3/ni_20141016_final-amendments-related-forms.pdf on February 25, 2015) 14 2015 PureFacts Financial Solutions. All rights reserved. This document is protected by international copyright law and may not be reprinted, reproduced, copied or utilized in whole or in part by any means including electronic, mechanical, or other means without the prior written consent of PureFacts Financial Solutions.

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